Is it too late to profit from the superstar FAANG stocks? History holds some surprises

There's a word for those people who loaded up on today's hottest technology stocks a few years ago. That word is "rich."

Facebook Inc., Apple Inc., Amazon.com Inc., Netflix Inc. and Alphabet Inc. (parent of Google) have powered Wall Street to fresh highs and for good reason. Many of the so-called FAANG stocks benefit from business models that look perfectly attuned to today's digital economy.

So let's address the question that may be rattling around the back of your mind. Is it too late to profit from this generation of tech superstars?

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History offers contradictory evidence. But, on balance, it suggests that leaping into the tech craze, even at this late point, isn't necessarily a horrible idea.

Consider what would have happened to an unfortunate investor who decided to buy the five biggest tech stocks in the United States at the very peak of the dot-com lunacy. In March, 2000, this unlucky person would have stocked his portfolio with Cisco Systems Inc., Microsoft Corp., Intel Corp., Oracle Corp. and IBM Corp.

At the time, each of these companies was an acclaimed world beater. Each appeared poised for even more triumphs ahead.

But things didn't work out quite so splendidly. Over the next 17 years, this portfolio of tech all-stars would have generated an average annual return of a measly 0.7 per cent. (That's assuming you began with the same dollar amount of each stock and reinvested dividends in the stock that generated them. The returns are calculated in U.S. dollars to avoid currency effects.)

That's not a great result. However, it's also not horrible if you consider that this represents the absolute worst that would have befallen someone who arrived late to an extraordinarily expensive party.

By comparison, someone who bought a plain-vanilla S&P 500 index fund in March, 2000, would have enjoyed an average return of 4.8 per cent a year between then and now. The index investor would be well ahead of the tech investor, but not by as much as you might think.

The situation becomes even more interesting if you look at what would have happened if you had arrived late to the dot-com party, but not quite as late as the first investor.

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Imagine, for instance, what would have transpired if you had bought the dot-com era's biggest winners in 1998. These hot stocks were already expensive at that point – several were trading for more than 30-times earnings – but not as expensive as they would be a couple of years later.

By buying in a bit earlier, you would have vastly improved your results. The numbers tell the tale: Between 1998 and 2017, the five giants of the dot-com era would have generated average annual returns of nearly 8 per cent. That substantially beats the S&P 500 results of 6.2 per cent a year over the same period.

The results demonstrate how relatively small differences in timing and stock selection can result in large differences in performance. To my mind, the results also provide comfort to those who think they're too late to reap profits from today's tech craze.

History suggests that buying a diversified selection of great companies, even at extremely high prices, is still likely to produce positive returns – at least, that is, if you're prepared to hold them for the long haul.

This holds true even if you dig back further, to the hottest 50 growth stocks of the early 1970s. Investors' love affair with the so-called Nifty Fifty, which spanned everything from Coca-Cola Co. and McDonald's Corp. to Polaroid Corp. and Xerox Corp., has often been derided as a classic example of Wall Street lunacy. However, Jeremy Siegel of the Wharton School of Business argued in a 1998 paper that the stocks were actually only slightly overvalued.

"A portfolio of Nifty Fifty stocks purchased at the peak would have nearly matched the S&P 500 over the next 26 years," he wrote. His conclusion? "Good growth stocks, like good wines, are often worth the price you pay."

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To be sure, that finding comes with a couple of major caveats.

One is that valuation still matters. Prof. Siegel found that growth stocks with lower price-to-earnings ratios tended to outperform their more expensive counterparts.

In addition, diversification is vital.

Results from the Nifty Fifty were all over the board. So were results from the dot-com darlings.

"Diversification is a key to cutting risks and maintaining returns," Prof. Siegel wrote years ago. The same holds true today. If you really want to bet on the FAANG stocks at this late stage, it makes sense to buy all of them, not just one.

Editor’s Note: In an earlier version, the return from a selection of dot.com-era technology stocks was incorrectly stated. It should be 0.7 per cent a year, not 3.3 per cent a year.